The financial industry and its regulators are stuck in an outdated debate as they continue to spar over which firms are so big that they should be overseen by one or more regulators. The latest round took place when the Financial Stability Oversight Council hosted a public conference in late May. Panelists discussed the question of whether certain asset management firms should be designated under the Dodd-Frank Act as systemically important financial institutions — so-called SIFIs — and thus be regulated by the Federal Reserve.

This is the wrong question to ask. In the era of shadow banking, regulators should focus not on which asset management firms to regulate, but on which asset management activities. Put another way: Regulators make a mistake when they target shadow banks. They should focus on shadow banking.

When they do so, they need to be clear about their regulatory ends. As regulators have pursued broad economic policy goals in the aftermath of the financial crisis, they have used every handle on banks that they already have. But many of these handles — such as capital requirements and lending limits — were largely designed to help regulators protect individual firms — not manage systemic risk. As a consequence, the discourse becomes particularly muddled.

For example, we end up with a perfect storm of misunderstanding when we debate whether the FSOC should designate asset management firms as SIFIs, which inevitably leads to a debate about how we would then apply regulatory capital requirements. Capital requirements make little sense when applied either to the biggest mutual funds, which borrow little or no money to start with, or to asset managers with the greatest amount of assets under management, which are not liable for the obligations of the funds they manage. What's more, capital requirements were originally designed to protect firms by ensuring that they have adequate capital — whereas regulators in this instance are attempting to use them to protect the economy as a whole.

The fact is that today we effectively create deposits through money market mutual funds; money market mutual funds lend large amounts of money to securities firms to finance securities portfolios; and securities in those portfolios are issued by securitization vehicles that hold loans and mortgages that banks once held. Given this extraordinary economic ecosystem, it is a mistake of habit to approach regulatory challenges in an entity-centric fashion. This may have worked when the economy's ebb and flow was bounded by the shores of the banking world, and regulating banks was equivalent to regulating the economy as a whole. But this is no longer the case, as the entities engaged in shadow banking are too diverse. Identifying these firms by their size alone does not ensure that we capture systemically important economic activities.

Regulators have a means for shifting their approach to shadow banking. Dodd-Frank gives the FSOC the power to address discrete financial activities in addition to designating SIFIs. Already the FSOC has exercised this power in the context of money market mutual fund regulation. Moreover, Federal Reserve Board Governor Daniel Tarullo spoke earlier this month of "the need to broaden the perimeter of prudential regulation, both to certain nonbank financial institutions and to certain activities by all financial actors" (emphasis mine). And in her opening remarks at the FSOC conference last month, Treasury Undersecretary Mary Miller discussed regulating asset management "activities."

The next step should be for the FSOC and its constituent regulators to declare that shadow banking activities, not shadow banks, are their primary sparring partners. They should also acknowledge that at just about every turn the regulation of individual firms is being used in an effort to reduce risk in financial system as a whole. This acknowledgement would clarify public policy discussions. It would help explain the broadly observed regulatory reluctance to entertain certain industry requests for relief. Those requests may be reasonable from the point of view of a particular firm or even an entire industry sector. But regulators' motivations and actions must be understood in light of their efforts to reestablish control over the economy.

Governor Tarullo has highlighted his macroeconomic ambitions for regulation in recent speeches, noting that the financial crisis brought about a consensus that "prudential regulation should be broadened to better safeguard the financial system as a whole." Although one may or may not agree with his specific ideas, Governor Tarullo forthrightly describes the already evolving mission of financial regulation. To this should be added an equally forthright acknowledgement from all financial regulators that the activities of shadow banking, rather than the financial firms engaged in them, will be front and center in the debate going forward.

William Shirley is counsel in the New York office of Sidley Austin. He specializes in legal matters related to the financial services industry, particularly those associated with Dodd-Frank and other regulatory initiatives that followed in the wake of the financial crisis.